Extensions and applications of Merton’s model of capital structure

Abstract

Merton’s structural model offers a powerful and intuitively appealing approach to the evaluation of a firm’s capital structure choices and market behaviour across a firm’s issued debt and equity securities. Historical empirical evaluations of the efficacy of the model to replicate observed behaviour in the context of firm choices and market prices have produced mixed results. We show by way of two distinct examples that adopting different metrics for the evaluation of the model’s performance exposes very positive results. We evaluate the performance of the debt and equity markets in Anglo American Plc and BHP Billiton Plc in the period 2006 to 2015 using Merton’s structural model. We consider the failure of African Bank using Merton’s structural model. Separately, we construct a robust, extended and expanded interpretation of the Merton conceptual framework that incorporates many real world features of firm behaviour and market activity. Notably, we introduce the notion of liquidity that captures the requirement for firms to settle all payments and receipts through a cash account. We show that this model captures observed market behaviour. We apply the model to the two examples introduced previously.